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States' Perspectives On Federal Tax Reform

The staff at Tax Analysts has spent the past two weeks poring over House Ways and Means Committee Chair Dave Camp’s tax reform proposal – all 979 pages of it. It has been an arduous task (and for many at Tax Analysts, a labor of love), but in the end, the proposals in the Camp draft will remain just that – proposals. But the Camp draft is important. My colleague Marty Sullivan explained why in his blog post “If the Camp Tax Reform Bill Won’t Pass, Why Is It So Important?“ One reason Sullivan noted is that the Camp draft includes insight from “hundreds of experts who deal daily with the realities of modern tax practice.” In other words, the proposals have been thought about, debated, and thoroughly vetted.

Not to mention, the draft is interesting. Even for a state tax practitioner, it’s interesting. For example, it proposes reducing the top federal corporate tax rate from 35 percent to 25 percent. This reduction would affect state corporate taxation insomuch as a state conforms to the Internal Revenue Code. Most states that have a corporate income tax use federal taxable income as the starting point for determining state taxable income. Modifications are then made (both additions and subtractions) to arrive at the tax base, which will be apportioned to each state in which the corporation does business.

In simplified terms, then, a reduction in the federal corporate income tax rate could translate into reduced state corporate income tax revenue. Of course, states can decouple from some IRC provisions to increase revenue. For example, during the lean budgetary years of the Great Recession, many states decoupled from IRC section 168(k), which increases the depreciation expense for the first year an asset is placed into service (bonus depreciation).

The Camp draft also proposes shifting to a territorial corporate tax system. Currently (and very basically), companies in the U.S. are taxed on their worldwide income, although they can defer taxes on foreign income if the income is actively invested outside the U.S. A territorial tax system would tax income earned in the U.S. and would eliminate the deferral of tax on foreign earnings.

There are complicated rules surrounding the implementation and effect of a territorial tax system. From a state perspective, a territorial system could increase revenue (for example, because of increased repatriation of foreign dividends), but the effect would depend largely on whether the state conforms to the IRC on a static or rolling basis or whether the state chooses not to conform. Nonconformity to a change like this would significantly increase compliance complexity for taxpayers and enforcement for tax administrators.

But issues of federal conformity would not be the only state implications of the Camp draft. For example, the draft includes a provision that could affect the way states structure their incentive programs. Under current law, a tax reduction (which includes an abatement, credit, deduction, rate reduction, or exemption) given to a corporation as an incentive to locate in, remain in, or expand in a particular state or locality is not included in the corporation’s gross income.

The Camp draft would revise the treatment of contributions to capital by including in a taxpayer’s gross income contributions “other than a contribution of money or property made in exchange for stock of a corporation or any interest in an entity”. That means that if a locality gave land to a corporation, the value of the gift could be a contribution to capital that could be included in the corporation’s gross income. This reduces the benefit of the “gift” by the locality. If something like this were enacted, states and localities might have to adjust their use of land as a means of economic development.

The feasibility of the ideas in the Camp bill will be debated in the coming months. At nearly 1,000 pages, the Camp draft is a monster of a bill. But it puts a lot of ideas on the table, and at least in the tax community, it will generate a lot of discussion.

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For any state that receives revenue through real estate transactions, Camp’s proposals to limit deductions of mortgage interest , eliminate deductions of state and local taxes and to eliminate 1031 tax deferred exchanges are a serious attack to this vital part of the economy. These proposals will reduce revenue to state and federal governments.